A Double Blow to Split-Dollar Life Insurance

Split-dollar life insurance may have been the last thing on Jeffrey Skilling’s mind when he was led away in handcuffs on February 19, but his split-dollar policy was one of many that spurred regulators to rethink these arrangements in the wake of the Enron disaster. Former Enron CEO Skilling and former chairman Kenneth Lay reportedly used their tax-advantaged split-dollar policies to accumulate massive wealth, avoid taxes and shelter their deferred compensation from the company’s creditors.

Until recently, companies commonly used split-dollar policies to provide executives with tax-free premium payments for $5 million to $50 million in life insurance. Under these policies, the employer typically buys life insurance for senior executives, with the premium payments and cash-value accumulation treated as a "loan" to the employee, and the employer holds the right to some portion of the cash value and death benefit.

The first blow to the policies came with the 2002 Sarbanes-Oxley Act, which restricts corporate loans to executives. "Public companies should discontinue payments under split-dollar arrangements for officers and directors until such time as the SEC clarifies the applicability of Sarbanes-Oxley to the plans," says Margaret Gallagher Thompson, chair of the trusts and estates practice group at Cozen O’Connor in Philadelphia.

The IRS and the Treasury Department issued the second blow to split-dollar policies in the form of new regulations proposed in 2002 and finalized on September 11, 2003. The new regulations apply to all companies and all employees covered under split-dollar arrangements entered into or "materially modified" after September 17, 2003. "From the perspective of all parties involved, including HR executives, the new regulations clearly make these plans less attractive, and fewer life-insurance professionals will be zealously presenting them," says Byron Udell, president and CEO of AccuQuote, a life insurance brokerage firm.

Tax bite The regulations stipulate that the tax treatment for split-dollar arrangements will now be determined under two different tax regimes, depending on who owns the policy. The new "loan regime" rules cover most collateral-assignment systems, where the employee usually owns the policy and assigns a portion of the cash value and death benefit to the employer in return for the premium payments and cash-value increases "loaned" to the employee. Unless the employee is required to pay the employer market-rate interest on the loan, the employee will be taxed on the difference between the market rate and the actual interest being charged.

The new "economic benefit" regime rules cover most "endorsement" systems, where the employer owns the policy and its cash value, and the employer’s premium payments are treated as a taxable economic benefit to the employee. The economic benefits to be taxed include the employee’s interest in the policy’s cash value and current life-insurance protection.

Because the new regulations define split-dollar arrangements in broad terms, Thompson advises workforce-management professionals to take a look at their insurance policies that they may not commonly think of as split-dollar--because they may actually fall under these new rules. This could include any insurance arrangement, other than group term plans, in which the employer pays all or part of the premiums and will recover the premiums from policy proceeds or cash value, and the employee names the beneficiary or has an interest in the policy’s cash value.

"The effects of the new regulations on split-dollar programs are significant and complex," says Kristin Barens, managing director, Mullin Consulting. "The final regulations could dramatically increase a participant’s tax under collateral-assignment arrangements. Companies should quantify the additional participant tax to see if it makes sense to terminate or modify these arrangements." The final regulations have less impact on endorsement arrangements. A quick examination of endorsement arrangements can determine whether modifications would be advantageous.

Companies should also monitor the plans more closely. "For arrangements operating under the old rules, the HR executive should be certain that the economic benefit is properly paid by the employee, or reported to the IRS for tax purposes," advises Lynne F. Stebbins, vice president, advanced planning and professional services, The Guardian Life Insurance Company of America. "The economic-benefit split-dollar arrangements will be used more widely for lower-level key employees and managers in an effort to provide life-insurance protection in addition to a basic group life-insurance plan."

Alternatives Employers looking for alternatives to split-dollar policies can choose from a number of viable options. Barens says that if the participating employees value all aspects of their current split-dollar arrangement, a tax increase resulting from the final regulations may not necessitate a change to the existing benefit.

If they value only certain elements of the policy, such as the death benefit, options include a premium bonus program to cover the costs of buying individual life-insurance coverage or providing additional supplemental individual or group term-insurance coverage. Variations on these options can also be implemented as separate strategies or used in combination to meet both corporate and individual needs.